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All froth: Luckin Coffee, whose store count outstripped Starbucks' in China, claimed high-tech credentials as it expanded rapidly through the country and listed overseas.   © Nikkei montage/Source photo by Yuki Kohara
The Big Story

The Luckin scandal: fake sales, power struggles and a 'broken model'

How a Chinese tech darling went from startup wonder to market pariah

HENNY SENDER, Nikkei Asian Review columnist | China

HONG KONG -- When the prospectus for Luckin Coffee's New York listing was published last May, nowhere was it more intensely scrutinized than in the offices of Warburg Pincus, high above Grand Central Station.

The investment firm knew the personnel behind Luckin, a downmarket Chinese coffee chain, very well. The fund had invested in China Auto Rental, an online car hire business founded by Lu Zhengyao, Luckin's chairman. Several members of Luckin's board had also worked at CAR. David Li, another board member, had been head of Warburg's own China team between 2012 and 2016, when he left to start his own private equity company, Centurium Capital. It was Li who had first introduced Lu to the people at Warburg.

CAR had been a roaring success and ultimately listed on the Hong Kong stock exchange in 2014. Since its founding in 2017, Luckin had grown enormously fast, boasting more outlets than Starbucks and more than $1.5 billion in investments. But the private equity firm felt that the founder had lost his way. They passed on the opportunity to back Luckin.

"The audacity of what he did with CAR was impressive," said an investor close to Warburg. "But then the characteristics of a successful entrepreneur -- the drive and the ambition and hard work -- went to his head. He forgot what made him successful and he stopped the hard work."

As executives at the firm reviewed the coffee chain's offer memo, they felt vindicated in their decision. Lu and Li "were too hungry," says one former Warburg executive. "They created a capital markets story, not a substantive company."

Luckin Coffee listed on the Nasdaq to great fanfare in 2019 -- and delisted just over a year later in the wake of an accounting scandal.   © Reuters

The Warburg executives were right. In April this year, the coffee chain admitted that at least $310 million of its sales over the previous three quarters had been fabricated. Following the revelation, the company dismissed its chief operating officer, Jian Liu, and chief executive, Jenny Qian Zhiya. Chinese regulators began investigating Lu himself. The news was originally reported by Caixin and independently confirmed by the Nikkei Asian Review. Then, on July 5, Lu and Li were removed at a special shareholders' meeting in Beijing. Two others -- Sean Shao, the independent director leading the company's internal investigation, and Liu Erhai, founder of Luckin investor Joy Capital, were also ousted.

Today, Luckin's very survival is in doubt, and the company's shares have been delisted.

The scandal at the company has raised many questions for investors: about the obsession with a growth over profits model that still drives the venture capital industry; about how easy it was to claim high-tech credentials for a low-tech model; and about the reliability of corporate governance standards in China. All could have serious consequences for the future of Chinese companies as they try to list on international exchanges.

The revelations are made more alarming by the fact that, to many, Luckin's shortcomings were clear from the start.

Red flags

On May 17, 2019, the day of the Luckin listing, the coffee and champagne flowed freely at Nasdaq. The company had been dubbed "China's Starbucks" by the financial press, a concept that was simple for investors to grasp. The stock, which made its debut at $17 a share, had risen 20% by the close of the day, giving Luckin a valuation of $4 billion -- not bad for a company not even two years old.

The investment backdrop made it all the more remarkable. Markets were already beginning to fall out of love with cash-burning consumer internet companies, particularly those unable to tell their investors with any specificity when they would ever actually produce a profit.

A week earlier, ride-hailing pioneer Uber Technologies had made a disappointing debut. Its bankers had whispered about a possible $120 billion valuation, but even with an initial public offering priced at the bottom of its range, the stock closed down 7.6%.

Just like Uber, Luckin was incurring heavy losses -- and at a widening rate. Its first quarter loss came in at 550 million yuan ($77.8 million), which senior executives attributed to a weak Lunar New Year holiday period. The company managed to charm investors anyway.

Superficially, its pitch was compelling. Lu was building a company that was not just a cheaper clone of Starbucks -- although his stated ambition was to be bigger than his American rival. Luckin was also a data and e-commerce play. The vast majority of its outlets were stalls where customers picked up coffee on the go, and the customer experience was mostly online. All of its transactions took place on the Luckin app, allowing the company to build a massive database of middle-class Chinese consumers. It added e-commerce functions and signed deals with food delivery services. With that network, it promised a kind of optimized, digitized experience that resonated with tech investors.

"Tech has reshaped their business model," Li said on the day of the listing. "We have all the data; we have heat maps from where orders originate, so we can put stores in places where the orders come from."

Despite some skepticism, the market was awash with liquidity, and investors were still piling into Chinese new economy companies in search of the next Alibaba Group Holding or Tencent Holdings. Although Warburg Pincus declined to invest, others -- including BlackRock, Fidelity and Singapore's GIC Capital Management -- did, either directly or through Centurium Capital. Credit Suisse and Morgan Stanley, underwriters for CAR's Hong Kong listing, reprised their role for Luckin.

As recently as last year, the then-CEO of Credit Suisse, Tidjane Thiam, called Lu "a dream client," speaking at a conference. "I've had I don't know how many dinners with [Lu] in Beijing and he's absolutely the poster child for what we want to do," Thiam said.

Luckin Coffee's growth was impressive, but there were some major questions over its business model. Its sales were heavily subsidized, meaning that its unit economics were unsustainable. To make a profit, it would need to drastically raise the price of its coffee.

The prospectus noted that among the company's risks was the fact that many of the outlets from which it was currently selling coffee did not have the requisite regulatory approvals.

There was also a loan -- described by one director as a "bridge loan" -- to Lu from one of the company's banks, which the chairman had then on-lent to Luckin. Details of that remain unclear. When pressed at the time, spokespeople for Luckin, and Reinout Schakel, the chief financial officer, a newly recruited European who did not speak Chinese, declined to comment.

Absent from the prospectus was Fei Yang, the chief marketing officer of Luckin, and previously of CAR subsidiary UCAR. In 2015, Fei had been sentenced to 18 months in jail for breaking Chinese advertising laws.

Luckin Chairman Lu Zhengyao, exuberant on the day of the Nasdaq IPO: As recently as last year, he was decribed as a "poster child" for Chinese entrepreneurship abroad.   © Reuters

One investment banking associate who worked for one of the lead managers on Luckin's IPO said their due diligence threw up some other red flags. For example, there were discrepancies between the number of coffees that the company claimed to be selling and the number of coffee cups that were being taken out of inventory. These concerns were flagged to senior management but were not seen as significant.

Given these issues, why was Luckin in such a hurry to get to market? Why did the company not wait another few months and go public with better sales figures and the right regulatory approvals in place?

The answer was simple. "Any cash-burning company needs to tap the market quickly, before it shuts," said the investor close to Warburg Pincus.

In January 2020, Luckin raised another $865 million, issuing more shares and a convertible bond. Up to that point, Li's Centurium Capital had been bound by an obligation to retain its entire investment. That requirement expired in January, and Centurium sold down its shareholding, retaining a 7% stake.

Lu and Qian both pledged large amounts of their shareholdings to units of the underwriters as collateral for loans in a form of cashing out. The underwriters have already said they expect to lose a substantial amount of that money, given the plunge in the value of the shares.

From the beginning, there were many hedge fund managers who were skeptical of the coffee chain's prospects. However, few actually shorted Luckin's stock because to do so was prohibitively expensive.

Lu, Li and Qian controlled a big portion of the stock, and with so many shares in the hands of insiders it was risky for bearish investors to approach the brokerage firms who act as intermediaries and obtain shares to short. The borrowing cost could spiral, and the shares could be recalled at any time.

Discrepancies showed up as companies did due diligence on Luckin, but were not seen as significant at the time.   © Reuters

One Hong Kong hedge fund manager says he considered shorting but decided the potential downside for his fund was too great. "It is the most risky thing in our business. ... Often you have to cover your position at the absolute wrong price -- even when you know you are right."

This meant Luckin's share price was artificially robust throughout most of its life as a public company. In the end, though, it was a famous short seller that blew the whistle on Luckin.

Murky waters

Not long after Luckin's capital raising in January, the hedge fund Muddy Waters announced it was shorting the stock, citing a damning anonymous report on the coffee chain. It was a vast exercise in detective work. The authors had dispatched nearly 1,500 investigators to count sales and record traffic at 600 Luckin stores. By the end, they had recorded more than 11,000 hours of video and collected nearly 26,000 customer receipts.

The report concluded that Luckin had inflated the number of items being sold by 69% in the third quarter of 2019 and by 88% in the last quarter, and that the net selling price per item had been overstated by more than 12%. The authors estimated that rather than making money, net loss at the store level was 28%. Revenue contributions from non-coffee products -- the basis of Luckin's growth plan -- had been overstated by 400%, according to the report.

"When Luckin Coffee went public, it was a fundamentally broken business that was attempting to instill the culture of drinking coffee into Chinese consumers through cutthroat discounts and free giveaway coffee," the report said. "Right after its IPO, the Company had evolved into a fraud by fabricating financial and operating numbers. Luckin knows exactly what investors are looking for, how to position itself as a growth stock with a fantastic story, and what key metrics to manipulate to maximize investor confidence."

Although the fraud dominated the headlines, the report was also highly critical of Luckin's business model, which was overreliant on discounting. For it to be profitable, prices would have to rise, and customers would desert the brand, the report says. The model would never work, it concluded.

Luckin initially dismissed the allegations and disputed the report's methodology. In April, however, it confessed to one of the main findings: Sales had been vastly overstated.

The company said a special audit led by Ernst & Young found that Luckin's chief operating officer, Liu Jian, and other employees had carried out a scheme to fabricate more than $300 million in revenue over the six months ending Sept. 30. The stock tumbled by more than 90% from its high in January.

In May, before it was revealed that he was being investigated by the regulator, Lu issued a self-pitying apology, saying: "My style might have been too aggressive and the company may have been growing too fast. I have been in deep pain and remorse. I can't sleep at night. I will do my best to retrieve shareholders' losses."

Meanwhile, the ripple effects of Luckin Coffee's implosion have been massive. The past decade has seen numerous frauds involving Chinese companies listed offshore, in markets from New York to Singapore to Toronto. But this one seems to have had far greater impact.

For one thing, it has provided fuel for anti-China rhetorical fire in the U.S., just as the two countries' sparring ground moves from trade to finance. Congresspeople on both sides of the aisle are considering barring Chinese companies from access to U.S. capital markets. In May, the U.S. Senate approved a bill that would force Chinese companies to delist if they fail to comply with American regulatory audits for three consecutive years. Under Chinese rules, audit papers for overseas-listed companies must be kept in China, where foreign regulators cannot access them.

In response to the scandal at Luckin, Chinese regulators -- who have typically sat on the sidelines when mainland firms listed abroad are mixed up in fraud allegations -- have sprung into action with unusual alacrity to demonstrate both their concern and their determination to take punitive action against miscreants.

There is a "need for the Chinese government and the nation's entrepreneurs to make their corporate governance understandable and acceptable to the rest of the world," said former central bank governor Zhou Xiaochuan, speaking at the Lujiazui Forum in Shanghai on June 18. That followed at least three references to the scandal from Chinese Vice Premier Liu He in the weeks after the revelation of the falsified accounts.

Luckin's inflated numbers point to challenges for investors in consumer internet companies: The difficulty in verifying claims of how many monthly or daily consumers they actually have on their platforms, and how much the companies themselves actually subsidize their users' purchases.

This is not just a China problem. Even investors from the world's most respected venture capital firms say that, on occasion, they have difficulty verifying numbers during the course of their due diligence on the other side of the Pacific.

Before putting money into a consumer internet company, investors will often hire an accounting firm to verify sales and estimate subsidies. If a ride-sharing company has a receipt claiming a 200-km ride in the small city-state of Singapore, it is easy to establish that the receipt isn't genuine. But rarely is a falsified figure that blatant. Investors whose credo is "trust but verify" must often resort to simple trust at the end of the day.

The challenge is further complicated by the fact that virtually all consumer internet companies start out heavily subsidizing their sales and "adjusting" their numbers. On a stand-alone basis, the figures are never reassuring. Their ultimate survival depends on eventually convincing consumers to pay real money for their services, on having deep-pocketed strategic investors such as Tencent or Alibaba in China, or Google or Facebook in the U.S. -- or on undertaking a new activity that generates profits.

For years, Amazon lacked a clear path to profitability. Even today, Amazon's core business hardly makes profits. But the cloud business has saved Amazon from naysayers and compensates for the slimmer margins of its consumer business.

Moreover, in some cases, investors facilitate or at least acquiesce to questionable practices. "Many startups use their investors' cash to survive," said Eddie Tam, founder of hedge fund Central Asset Investments in Hong Kong. "Any financial improvement just comes from burning their investors' cash. New money replaces old money. They never clean up their act over time. They are bleeding-edge, not leading-edge business models."

"Many startups use their investors' cash to survive. ... They never clean up their act over time. They are bleeding-edge, not leading-edge business models"

Eddie Tam, founder of Hong Kong-based hedge fund Central Asset Investments
A Luckin outlet in Shanghai in April: The company's sales were heavily subsidized, and a route to profit would have involved dramatically raising prices.   © AP

The fate of companies, then, is to either evolve or die -- or to cross the line into fraud. And in the consumer internet, the line between subsidizing sales and inflating them can appear gray. "Tech facilitates crossing lines," said the former Warburg executive.

As a private company, the lines are blurred. But there is no such fuzziness in public markets.

"You subsidize customers based on algorithms. But then you need to wait for the network effect to kick in," said a Beijing-based executive at an international alternative investment company. "But in the tech world, it takes a [long] time to prove your business model. The IPO came too early. They were too eager to cash out."

Fire sale

In the aftermath of the falsified figures' discovery, Lu's empire began to unravel. In early May, a slide in CAR's stock price -- already under pressure as market share and profits fell -- accelerated in the wake of the revelations about Luckin. The underwriters to which Lu had pledged shares as collateral prepared to dump their stakes. Warburg moved quickly to increase its stake at a bargain price. "There is a difference between a longtime strategic holding and a tactical investment," explained one person close to Warburg.

A key figure in the still-unfolding drama is Lu's closest associate, Luckin non-executive board member David Li, who funded the firm's A and B capital raisings.

The son of a general in the People's Liberation Army, he went to business school at Yale, one of a group of mainland returnees who include some of the brightest investors in China today.

While at Warburg and then at Centurium, Li turned Lu's ideas into companies that could meet the standards necessary to attract outside capital, whether from investment firms such as Warburg Pincus, from strategic investors, or from the public markets. He has always denied any knowledge of the wrongdoing, despite financing the early capital raising and taking Centurium's money off the table back in January. Li expressed shock at the news of the fabricated sales, according to his spokeswoman.

Still, given his deep pockets, he is likely to be a target of public market investors and creditors.

A jubilant management team at Luckin's Nasdaq IPO: Lu claps at the center, with former CEO Qian Zhiya, right, and close associate David Li, left; CFO Reinout Schakel cheers in the back row.   © Reuters

People who know him say that Lu is not a particularly sophisticated businessman. He was a first-generation entrepreneur whose strengths were his vision and instinct. "He never understood capital markets or financial engineering," says one venture capitalist who first met Lu when he was creating his car companies. "He relied on others to execute."

When both were ousted from the board of the company they helped to create, it looked like closure. But there may be one more round of machinations to come.

Public market investors in Luckin and former colleagues believe that Lu is now playing a more complicated game. They told Nikkei they believe that since Lu controls such a big portion of the voting shares, he triggered the shareholders' meeting that led to his own removal -- and that of Li and Joy Capital's Liu.

Li and Liu have both denied any knowledge of the fraudulent figures and are anxious to distance themselves from Lu. Their replacements on the board are two other investors believed to be close to Lu, according to people familiar with the matter.

"It is a fight over control of the direction of the investigation," said one person who has worked closely with the principal figures in the scandal. "Whoever is no longer in the room becomes the object of the investigation, while those who are in the room control the flow of information and the documentation and the data to point at those outside." Even though Lu has lost his seat on the board, the person said, it might be wrong to bet against him. "Lu is a street fighter."

Additional reporting by Nikkei Asian Review chief banking and financial correspondent Narayanan Somasundaram in Hong Kong.

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